Some Fear Shakeout In Triple-B Debt Arena

U.S.
companies have been bulking up on debt, introducing another wild card into
financial markets already rattled by the recent tech selloff and the prospect
of rising interest rates.

One slice of the
high-grade corporate bond universe is fast becoming the epicenter of these
concerns. There is $2.5 trillion in outstanding U.S. debt rated triple-B,
according to Morgan Stanley , up from $1.3 trillion five years ago and $686
billion a decade ago. That is the most ever for companies rated triple-B, which
is the lowest rung of the ratings ladder for companies that are above more
speculative, or junk, bonds.

The
fear: If the long economic expansion takes a turn for the worse, investors
could jettison the debt of more leveraged borrowers such as triple-B issuers.
That would further weigh on companies and potentially exacerbate any
contraction.

The
International Monetary Fund recently highlighted the triple-B risk in a report
on financial stability that warned about “a buildup of financial balance sheet”
debt.

“When markets start restricting access to
capital in a downturn or a bear market, we tend to find that leverage levels
matter a lot,” said Adam Richmond, a credit strategist at Morgan Stanley.

Triple-B
rated bonds, which now account for 50% of the investment-grade market, have
weighed on overall returns for high-quality debt this year. They returned
negative 2.2%.

And
that wasn’t just due to rising short-term interest rates. Notably, bonds above
and below triple-B on the ratings ladder did better. Double-A bonds fell 1.8%,
while junk-rated single-B bonds were down just 0.6%.

Growing
apprehension over debt levels is another sign that investors are retreating
from risk and are increasingly questioning whether long bull markets in stocks
and bonds are nearing an end. Highflying technology stocks have been crushed in
recent days, despite rebounding a bit on the final day of trading last week.
More broadly, stocks have swung wildly during the past two months as worries
over inflation have emerged for the first time in years.

As
the new quarter begins, some money managers are fearing a shakeout.

“There’s
enough manic news in the marketplace right now to keep investor nerves on
edge,” said Tom Stringfellow, president and chief investment officer of Frost
Investment Advisors, a $3.7 billion advisory firm.

In
contrast to junk bonds, those most often associated with leverage, high-grade
corporate bonds are considered to be some of the safest debt, often held in the
bond portfolios of everyday investors and a cornerstone for big institutional
investors like pensions.

Some
investors are concerned that the rating scale doesn’t fully reflect the risks
in a less hospitable market environment. An economic slowdown that hits
companies’ sales and profits, for example, would spur a rethink of the current
ratings breakdown, investors say, potentially leading to many market-roiling
downgrades.

“It
does appear there may be some overrating, at least compared to history,” said
Gene Tannuzzo, a bond manager at Columbia Threadneedle Investments, referring
to companies having higher ratings than they should. He said he has avoided
some recent debt sales due to leverage concerns.

For
now, default rates remain low, making elevated debt levels more of medium-term
worry for investors than an immediate crisis. Companies have also had an easy
time refinancing their debt with interest rates at rock-bottom level, though
that could become more difficult and costly in a rising-rate environment. And
as long as the economy and corporate earnings continue to grow, debt burdens
may be less of a concern.

But
there are signs the benign lending environment is eroding. Since Feb. 2, the
extra yield that investors demand to own triple-B rated bonds relative to
Treasurys has climbed to 1.34 percentage points from 1.08 percentage points,
according to Bloomberg Barclays data.

McDonald’s Corp. recently sold $500 million of 30-year bonds at a
yield of 1.4 percentage points above the comparable Treasury yield. Just before
the deal was marketed, the company’s existing bonds with the same maturity
traded at a 1.29 point spread, according to MarketAxess. That means the company
had to make a meaningful concession to investors to get the deal done.

One
reason why the amount of triple-B debt is at record levels: Once highly rated
companies have bulked up on debt over the years. McDonald’s, for example, was
rated AA by S&P and Aa2 by Moody’s in 2001. Today, the fast- food retailer
is rated BBB+ by S&P and Baa1 by Moody’s—a five-notch drop down the ratings
ladder as its total debt more than tripled.

The
use of cheap debt to finance megamergers is another factor driving up the
amount of lower-rated bonds.

Pharmacy chain CVS Health Corp. issued $40 billion of bonds in March to help pay
for its acquisition of health insurer Aetna Inc. boosting its debt load.
Moody’s Investors Service has put CVS ’s Baa1 rating on review for a downgrade, while
S&P Global Ratings has already dropped it to BBB from BBB+.

Credit-rating
firms say that in some circumstances, rising debt levels may be a temporary
phenomenon related to M&A activity. But the increased leverage, on balance,
makes these companies more vulnerable to future downgrades.